The tax implications
Treatment of transaction amounts as “interest” for tax purposes is construed as offensive
THE PROPOSED new section of the Act brings three types of Islamic financing transactions within the tax net, removing interest from the equation, including:
Mudurabah: A form of deposit where clients invest with the bank and, in turn, the bank invests their deposits in Shariahcompliant enterprises or products. The profits are shared in a predetermined ratio between the bank and its clients, who bear the risk of a loss on the investments.
The bank earns management fees and bears the risk of operational losses arising from the administration of the arrangement. Any profit derived by the client in consequence of the investment in the deposit account will, for tax purposes, be taken to
Murabaha: A form of asset financing. The bank buys the asset and pays the provider. The asset is resold to the client by the bank at a mark-up and the client pays the bank in instalments. The bank’s margin on the transaction is calculated by reference to the interest that would have been raised on a conventional transaction.
The bank’s margin on the resale of the asset to the client will, for income tax purposes, be treated as interest. For VAT purposes, the client will be taken to have bought the asset directly from the supplier at the price imposed by the supplier. ( The bank buying the asset, and its resale to the client, will accordingly be ignored for VAT purposes.)
A similar approach – a deemed direct acquisition of the property by the client, without intermediation by the bank – will also be applied for transfer duty purposes. Transfer duty will accordingly be levied only on the original buying price and not on the mark-up imposed by the bank.
Diminishing Mushasaka: A form of partnership commonly used in the context of project financing. The client and the bank jointly buy project assets; the bank’s share in the assets is divided into units and the units are progressively bought by the client. For as long as the bank retains ownership of the units, the client pays the bank rent on the unsold units. The rent will diminish as ownership of the units passes to the client.
The bank’s units (ownership interests) in the asset are leased to the client pending the progressive buying of the units by the client. The rent paid on the bank’s units will, for income tax purposes, be taken to be interest.
For VAT purposes, the client will be taken to have acquired the assets at the outset and directly from the supplier at the supplier’s price. A similar approach will be adopted for transfer duty purposes.
While the treatment of transaction amounts as “interest” for tax purposes might be construed as offensive, given the deliberate avoidance of interest under Shariah precepts, it should be appreciated if the amounts in question were not to be treated as interest for tax purposes the client might be deprived of the right to claim a tax deduction, even where a deduction would have been claimable pursuant to a conventional financing transaction.